FBIAS™ Fact-Based Investment Allocation Strategies for the week ending 2/7/2014

The very big picture:

In the “decades” timeframe, we are in a Secular Bear Market which began in 2000 when the P/E ratio (using Shiller’s Cyclically-Adjusted P/E, or “CAPE”) peaked at about 44.  The job of Secular Bear markets is to burn off outrageously high P/E ratios over one or two decades, until finally the P/E ratio arrives back at a single-digit level, from which another Secular Bull Market can emerge.  See graph below for the 100-year view of this repeating process.

If history is a guide, we may not yet be done with this Secular Bear Market.  The Shiller P/E finished the week at 25.0, up a small amount from the prior week’s 24.8, and approximately at the level reached at the pre-crash high in October, 2007.  Even though P/E’s are substantially lower than their crazy peak in 2000, they are nonetheless at the high end of the normal historical range and leave little if any room for expansion.  This means that the stock market is unlikely to make gains greater than corporate profit growth percentage, if that.  (note: all P/E references are to the Shiller P/E values, sometimes called PE10 or CAPE, which are calculated so as to remove shorter-term fluctuations; see robertshiller.com for details).

In fact, since 1881, the average annual returns for all ten year periods that began with a CAPE at this level have been just 3%/yr (see graph below).

This further means that above-average returns will be much more likely to come from the active management of portfolios than from passive buy-and-hold.  Although a mania could come along and cause P/E’s to shoot upward from current levels (such as happened in the late 1920’s and the late 1990’s), in the absence of such a mania, buy-and-hold investors will likely have a long wait until the arrival of returns typical of a Secular Bull Market.

In the big picture:

The “big picture” is the months-to-years timeframe – the timeframe in which Cyclical Bulls and Bears operate.  The US Bull-Bear Indicator (see graph below) is at 66.7, down from last week’s 68.2, and still solidly in cyclical Bull territory.  For the last two years, the US Bull-Bear Indicator has pushed further into Bull territory than other global asset classes, reflecting the higher strength of the US relative to the rest of the world.  The current Cyclical Bull has taken the US to new all-time highs, exceeding the highs of 2007, but most of the world’s major indices have barely matched 2011’s highs, let alone approached 2007’s levels.

In the intermediate picture:

The intermediate (weeks to months) indicator (see graph below) is in negative status, and sat at 16 at the end of the week, down from the prior week’s 21.  Separately, the quarter-by-quarter indicator – based on domestic and international stock trend status at the start of each quarter – gave a positive indication on the first day of January for the prospects for the first quarter of 2014.

Timeframe summary:

In the Secular (years to decades) timeframe (Figs. 1 & 2 above), the Secular Bear still is in force as the long-term valuation of the market is too high to sustain a new rip-roaring Secular Bull.  In the Cyclical (months to years) timeframe (Fig. 3 above), all major equity markets are in Cyclical Bull territory, with the US being far stronger than any other major market.  The Bond market is in Cyclical Bear territory as of June 7th.  In the Intermediate (weeks to months) timeframe (Fig. 4 above), US equity markets moved to negative status on January 29th.  The quarter-by-quarter indicator gave a positive signal for the 1st quarter:  both US and International equities were in uptrends at the start of Q1, which signals a higher likelihood of an up quarter than a down quarter. 

In the markets:

After a deep decline in the first half of the week, markets rebounded on Thursday and Friday to finish mixed for the week.  In the US, the Dow, the S&P 500 and the Nasdaq finished in the green, while the MIdCap and SmallCap indices finished in the red.  The average gain for all US indices was +0.2%.  Canada’s TSX gained +0.7%.  Developed International did the best of all major world groups, at +2.4%, while Emerging International gained an average +1.4%.  Reversing recent results, Brazil gained a sizable +3.6%, but China continued its recent poor performance, down -0.5%.  Emerging Markets continue to trail the rest of the world markets for the year to date, averaging  -7.3%

Although most investors think that Emerging Markets are highly correlated to the US (given the dependence of emerging economies on the health of the US economy), in reality the US and Emerging Markets can greatly diverge for years at a time.  The underperformance of Emerging Markets over the last several years is not unusual.  For example, looking at the past 25 years, there have been these consecutive periods of dramatic out- and under-performance:

US

(S&P 500)

Emerging Markets

(MSCI Emerging Mkts)

1988 – 1993

+122.0%

+545.4%

1994 – 1998

+193.9%

-38.5%

1999 – 2007

+38.1%

+420.1%

2008 – 2013

+43.7%

-5.2%

A big economic shocker in the US was the drop in the factory new orders index for January, which plunged the most since 1980.  However, Markit published data to show it was more of a correction of prior over-reporting than a reflection of a sudden dramatic industrial slowdown.  Friday’s non-farm payroll number was lower than most estimates, at 113,000 vs consensus expectations of 189,000, but investors gave it the benefit of the doubt and drove the Dow higher by triple-digits for the second consecutive day.

Canada’s employment report returned to the positive side of the ledger, reporting a gain of 29,400 jobs for January, following the shocking -45,900 December report.  In typical modest and understated Canadian fashion, Bank of Canada official Tiff Macklem spoke on the troubling lack of inflation in Canada, saying “We need to do our best to determine why inflation is below target, but no matter how hard we try, there will be uncertainty about our diagnosis.”  Canadian central bankers have expressed ongoing concern that deflation could derail the Canadian economy and have established a target of 2% inflation which has so far not been achieved.

In Europe, several countries which have been stagnating for years have begun to show life, at least in the Services sector.  Spain’s Services Purchasing Managers Index (“PMI”) increased to 54.9 in January, a strong start to the year.  Italian and French Services PMIs both rose in January also, increasing to 49.4 and 48.9, respectively, continuing recent improvements as they try to get back into expansion territory above the 50 level.  On the manufacturing side, the January Eurozone PMI came in at 54.0, the best since May 2011. Germany’s was 56.5, a 32-month high, while France edged up to 49.3, a 4-month high.  The biggest surprise came from Greece, which came in at 51.2 – the first time since 2009 Greece was in the expansion territory above 50.

(sources: Reuters, Barron’s, Wall St Journal, Bloomberg.com, ft.com, guggenheimpartners.com, ritholtz.com, markit.com, financialpost.com, Eurostat, Statistics Canada, Yahoo! Finance, stocksandnews.com)

The ranking relationship (shown in Fig. 5) between the defensive SHUT sectors (“S”=Staples [a.k.a. consumer non-cyclical], “H”=Healthcare, “U”=Utilities and “T”=Telecom) and the offensive DIME sectors (“D”=Discretionary [a.k.a. Consumer Cyclical], “I”=Industrial, “M”=Materials, “E”=Energy), is one way to gauge institutional investor sentiment in the market.

The average ranking of Defensive SHUT sectors rose slightly to 11 from the prior week’s 11.5, while the average ranking of Offensive DIME sectors also rose, to 14.5 from the prior week’s 16.5.  Defensive SHUT continued their higher ranking than Offensive DIME Sectors.

Note: these are “ranks”, not “scores”, so smaller numbers are higher and larger numbers are lower.

Summary:

The US led the recovery from 2011’s travails, and is the strongest among all global markets.  However, the over-arching Secular Bear Market may remain in place even as new highs are reached in the US.

Because we may still be in a Secular Bear, we have no expectations of runs of multiple double-digit consecutive years, and we expect poor market conditions to be a frequent occurrence.  Nonetheless, we remain completely open to any eventuality that the market brings, and our strategies, tactics and tools will help us to successfully navigate whatever happens.